Discount Rate (Pension)

How It Works

The discount rate is the most consequential and contested assumption in public pension accounting. Under GASB Statement 67 and 68, public pension plans typically use their expected long-term investment return as the discount rate (currently 6.5-7.25% for most plans, down from 8% a decade ago per NASRA). CalPERS reduced its discount rate from 7.5% in 2016 to 7.375% in 2017, then to 7.0% in 2018, then to 6.8% in 2021, each reduction increasing reported liability by several billion dollars. Financial economists (including Robert Novy-Marx at Rochester and Joshua Rauh at Stanford) argue that since accrued pension benefits are legally guaranteed obligations (protected by state constitutional clauses in Illinois, Arizona, Alaska, Hawaii, Louisiana, Michigan, and New York), they should be discounted at a risk-free Treasury rate (2-4%) consistent with FASB/private-sector pension accounting under ASC 715. Using a risk-free rate would roughly double reported public pension unfunded liabilities from approximately $1.4 trillion to over $4 trillion. GASB rejected this approach in 2012 after extensive debate, adopting a "blended" methodology where the expected return is used only to the extent projected assets cover projected benefits, with any uncovered portion discounted at a municipal bond index rate. In practice, most plans remain close to fully projected and use the single expected-return rate. The choice of discount rate is the single biggest reason that different analyses produce wildly different estimates of pension health. A 1-percentage-point reduction in the discount rate increases reported liability by roughly 10-15% for a mature plan. Discount rate assumptions affect every Public Plans Database funded ratio used in the 20% pension funding factor of the CitySpend Fiscal Health Score.

Related Terms

• Actuarial Assumption, The financial and demographic projections used to calculate pension costs and liabilities, including expected investment returns, employee life expectancy, and salary growth.
• Funded Ratio, The percentage of a pension plan's projected liabilities that are covered by current assets. A plan with $80 in assets for every $100 in liabilities has an 80% funded ratio.
• Unfunded Liability, The difference between a pension plan's projected liabilities (what it owes to current and future retirees) and its current assets. Also called the unfunded actuarial accrued liability (UAAL).